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ISLAMICFINANCE:CONCEPTUALANDANALYTICALISSUESFROMTHEPERSPECTIVEOFCONVENTIONALECONOMICS
AndrewShengPresident,FungGlobalInstitute,HongKong
TheThirdHolderoftheTunIsmailAliChair,UniversityofMalaya
Email:[email protected]
and
AjitSingh
EmeritusProfessorofEconomics,UniversityofCambridge
LifeFellow,Queens College,CambridgeCB39ET,UK
TheFifthHolderoftheTunIsmailAliChair,UniversityofMalaya
Email:[email protected]
November2011
Pleasedonotquotewithouttheagreementoftheauthors.Commentsmostwelcome.
ThispaperwaspresentedattheTunIsmailAliChairinMonetaryandFinancialEconomicsPublic
Lectureon14thNovember2011,SasanaKijang,BankNegaraMalaysia
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TableofContents
I. IntroductionII. CentralTenetofIslamicFinance:AbsoluteProhibitionAgainstInterestRates
III. EthicalFoundationsofIslamicFinance
IV. ModiglianiandMillerTheorems
V. RiskSharing,RiskShiftingandCostsofBankruptcy
VI. TheRoleoftheIslamicStockMarket
VII.
Summaryof
the
Main
Findings
and
Conclusion
References
TableI: AComparisonbetweenIslamicandConventionalBanking
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Apart from the IMF, a number of nonIslamic financial centres have also taken
steps to encourage Islamicbankingand finance. Tax lawshavebeen revised to
facilitateSharihcompliantfinancialinstrumentssuchasthelongtermsukukbonds
mentionedabove. Anotablerecententrant in thisfieldhasbeenthenonIslamic
centreofSingapore,whichhasstarteddoingbusinessinIslamicfinance.Anumber
of
non
Islamic
countries
in
Europe
including
the
UK
have
also
taken
legal
action
to
facilitate Islamic banking as these countries want a slice of this fast growing
market. There are, however, also examples of jurisdictions that have passed
negativelegislation,usuallyonpoliticalgrounds,toprohibitthespreadofIslamic
finance. ThiscategoryofcountriesincludessurprisinglySouthKoreaandperhaps
notsosurprisinglysomeindividualstatesintheUS.
The reasons for expecting fast expansion of Islamic finance lie not only in the
increasing
incomes
of
Islamic
populations
but
also
in
the
fact
that
the
basic
infrastructureforIslamicfinancehasnowbeenlaidwiththeestablishmentofthe
AccountingandAuditingOrganizationforIslamicFinancialInstitutions(AOFFI),
and the Islamic accounting standards authority, the Islamic Financial Services
Board (IFSB), the international Islamic financial regulatory standardsetting
organisation. TheInstituteforEducation inIslamicFinance (ISRA)alsoprovides
an invaluable website that is increasingly the transparent source for Sharih
interpretationsonwhatisconsideredacceptableunderIslamiclaw(Sheng2011).
The Islamic Finance Global Stability Report, which wasjointly producedby a
number of organisations in 2010, presents a comprehensive overview of the global
financialarchitecture andthecooperationandcollaborationmechanismsamongIFSBmembers
needed topromoteacompetitive, resilient,and stable Islamic finance industry. The Islamic
FinancialStabilityForumthatresultedfromthisReport,andtheInternationalIslamicLiquidity
Management (IILM), provide Islamic finance with awider range of tools and instruments, as
wellasaroadmapleadingtowardavisionofanintegratedandsoundglobalIslamicfinancial
industry.(AhmedandKohli,2011.Pg.xxvii)
With theabove empiricalbackground we turn now to the main purpose of this
paperwhichistheoreticalandconceptual. ItseekstorelatetheconceptsofIslamic
finance to those of conventional finance and to examine certain important
economic questions which arise from the interactionsbetween the two kinds of
theories. The paper is written selfconsciously from the perspective of
conventionaleconomics. Itidentifiessimilaritiesanddissimilaritiesbetweenthese
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twosystemsofthoughtandspeculatesontheextenttowhichthedifferencescan
beresolved. Thecentralconclusionofthepaperisanoptimisticone,namely,that
eachof the twoparadigmsof thoughthas itsownstrengthsandweaknessesbut
canneverthelesscoexistwiththeotherwithoutanyseriousdifficulties.
Therestofthepaperisorganisedasfollows:Thefirstpart,sectionsIIandIIIwill
discuss the two fundamental tenets of Islamic finance, namely, (a) absolute
prohibitionofinterestpaymentsondebt,and(b)thefundamentalethicalbasisof
Islamic law. These will be examined from the perspective of conventional
economicstoreachtheconclusionthatalthoughsomeofthestricturesofmodern
economics against the Islamic paradigm are inaccurate others are still relevant.
Importantly, thispartof thepaperhighlights themoralhazards facedby Islamic
depositorsaswellasby theirbanks. Theanalysisof thesesectionswillhowever
indicate
that
these
moral
hazard
problems
apply
to
both
Islamic
and
non
Islamic
financeandthatavoidanceofmoralhazardwoulddependontheeffectivenessof
the disciplinarian function of bank risk management, financial regulation, the
bankruptcy courts and also the ethics of the key players in each system. Since
thesemayhavedifferences inpractice indifferent countries, it isnotpossible in
principletoarguethatonesystemismoreeffectiveinmoralhazardavoidancethan
theother.
From
the
two
basic
tenets
of
Islamic
economics
the
second
part
of
the
paper
will
go
on to consider in sections IV,VandVI the important relevant tenetsofmodern
economics: (a) the so called Modigliani and Miller (MM) theorems and their
implicationsforoptimalcapitalstructureofIslamicbanksandfirms,(b)theroleof
the concept of bankruptcy, its costs and who pays the main costs, and their
consequences for moral hazard for Islamic and nonIslamic finance and, (c) the
efficientmarketshypothesisandthetheoryofstockmarketswiththeirapplication
toIslamicinstitutions.Under(c)thepaperwillprovideacriticalbutconstructive
analysis of the concept of an Islamic stock market. A concluding section will
summarisethemainfindingsofthepaperandprovideabriefconclusion.
Toelaboratefurtherthepaperwillgivespecialattentiontothefollowingspecific
issues:
a. In view of the absolute prohibition in Islamic finance to pay any kind ofinterestondebt,animportantquestioniswhetherornotitispossibletorun
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efficientlyan economic systemwhichdoesnothaveakey role for interest
rates?
b. What roledo interest rates play in conventional economicsata theoreticalleveland inpracticalterms?Canothervariablessubstituteforinterestrates
inalternative
economic
systems?
c. Why and towhat degreeare the households, firmsandbanks involved inIslamic financevulnerable tomoralhazard?Theconceptofbankruptcy, its
costs for contracting parties under the two systems and their relationship
withmoralhazardwillbeanalysed.
d.Whatare the implicationsofMM theorems for Islamicbanksand firms? Isthereanoptimaldebtequityratiofortheseinstitutions?
e. What,ifany,shouldbetheroleofthestockmarketinIslamicfinance? Tobeacceptableforthelatter,howwouldtheIslamicstockmarketdifferfromthe
conventionalstockmarket?
Although this commentary on Islamic concepts isbased on modern economic
analysis,itfullyacknowledgesthecontributionsofthegreatcontemporaryIslamic
economicscholars,includingamongothers,ProfessorsAbbasMirakhor,Mohshin
Khan, Ahmed Ali Saddiqui and the eminent late IMF economist Dr. V.Sundararajan.Thispaperbuildsasmuchontheworkofthesescholarsasonthatof
conventionaleconomists.
II. CENTRAL TENET OF ISLAMIC FINANCE:ABSOLUTE PROHIBITIONAGAINST
INTERESTRATESInthe1970swhenthesubjectofIslamicfinancewasfirstraisedinaseriousway,its
centraltenetoftheabsoluteprohibitionofinterestpaymentsondebtwasseverely
criticisedbymainstreameconomists. Itwasalleged that suchaprohibitionwas
incompatible with modern economic analysis and would result in a gross mis
allocationofresources. Itwasdubbedasazerointerestsysteminwhichtherewas
noreturntocapital.ProfessorMirakhor(2009)reportsthat theBBCandtheWall
StreetJournal regarded the systemasbeing totallynonviableandderived fromvoodooeconomics.
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Apart from these popular criticisms of Islamic injunctions against any interest
payments,therewerealsoseriousacademicobjections.ProfessorMirakhor(2010)
summarisesbelowthemainpointsofthesecriticisms:
thatzero interestmeant infinitedemand for loanable fundsandzerosupply;
such a system wouldbe incapable of equilibrating demand for andsupplyofloanablefunds;
withzerointerestratetherewouldbenosavings; thismeantnoinvestmentandnogrowth; inthissystem,therecouldbenomonetarypolicysincenoinstruments
of
liquidity
management
could
exist
without
a
fixed
predetermined
rateofinterest;and,finally,
thisallmeantthatincountriesadoptingsuchasystemtherewouldbeonewaycapitalflight.
Itshouldbenotedthatalltheabovecriticismswouldalsoapplytocountriesthat
practiceZeroInterestRatePolicies(ZIRP)underquantitativeeasing.
Incontrast
with
Islamic
economic
analysis
conventional
economists
widely
use
the
notion of interest rates in their work. In terms of their paradigm they have
legitimate use of zero interest rates, negative interest rates as well as positive
interest rates in examining real world economies. To illustrate, about half a
century ago, a leading Marxist economist of the time, Maurice Dobb (1960)
suggestedthatfromthesocialpointofview,therateofinterest,connotingsocietys
time preference, shouldbe zero. Individuals die while society goes on forever.
Thereisnoreasontofavouronegenerationoveranother.
In a parallel contribution around the same time, Maurice Dobbs pupil A.K.Sen
(1962, later to win the Nobel Prize) argued that even though society goes on
forever, in a growing economy, there shouldbe time preference for the present
whenpeoplearenotsorichastheywouldbeatafuturedate. Thiswouldindicate
normallyspeakingarelativelylowpositiveinterestrate(asopposedtoazerorate).
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Thatwouldallowarelativelygreaterconsumptiontodayandarelativelysmaller
consumptiontomorrowthanwouldotherwisebethecase.
In conventional economics the negative interest rates often arise from the
governmentsindustrialpolicywherethegovernmentwishestoencouragecertain
industriesandisthereforewillingtosocialisetherisksinvolvedfortheindividual
firm;inotherwordsthegovernmentsubsidisestherelevantactivitiesofthefirm.
Highpositiveinterestratesalsohaveaplaceinconventionaleconomicsanditmay
be useful to elaborate on this work in view of its claimed relevance to many
developingcountries,particularlyduring theprocessof financial liberalisation in
thesecountriesintherecentdecades. Theobviousreferencehereistothehighly
influentialworkinthe1960s,and1970s,andsubsequentlyofthesocalledStanford
SchooleconomistsMcKinnon(1973)andShaw(1973). Inaseriesofpapers,written
independently, the two economists argued strongly in favour of financial de
repression. Theysuggested that the liberalisationof the financialsystemwould
lead to higher interest rates and thereby to greater savings, investments and
growth. This work is controversial and its conclusions are contrary to much
mainstream economics as well as those of Islamic finance. It will thereforebe
useful to examine more fully the main assumptions and conclusions of the
Stanfordschool.1
The Stanford economists advanced inter alia, the following main propositions
concerningtheroleofinterestratesinlongtermeconomicgrowth(McKinnonibid;
Shaw ibid; for a classic review of the early literature, see Fry 1988; see also Fry
1997). First,financialdeepeningthroughgrowingfinancial intermediationand
monetization of the economy aids economic development. Secondly, financial
repression, whereby in many third world countries the Governments hold the
interest rates artificially low and provide subsidized credits either to favoured
sectors or to themselves, is inimical to long term economic growth. Thirdly,
liberalization of these repressed credit markets will foster development, since
raisinginterestratestotheirequilibriumlevelsleadsnotonlytohighersavings
butalsotomoreefficientuseofinvestmentresources.
1SectionsIIandIVdrawonandupdatethematerialinSinghandHamid(1992)andSingh(1995). SeealsoSingh(1997).
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Alltheseassertions,particularlythe lasttwo,aredebateablebothatatheoretical
level as well as empirically. It is not our purpose here to provide a detailed
analysisofthesepropositions. Sufficetosay,verybriefly,thatinthemainstream,
the Keynesian economists in particular, contest the McKinnon and Shaw
hypotheses on the ground that their underlying model assumes that savings
determine
investment.
Since
saving
is
done
by
different
economic
agents
(individuals and households), and investment is doneby other groups such as
firms and entrepreneurs there is no reason why savings should determine
investment. CriticsalsopointoutthatMcKinnonandShawassumethereisalways
fullemploymentofresources. Moreover,theysuggestthatwhetherornothigher
interest rates in the formal sector following liberalizationwill increaseaggregate
savings depends on the savingsbehaviour of the losers and gainers from this
process. To the extent that the personal sector finances the investments of the
corporate sector, which in developing countries are often highly geared, higher
interest rates may reduce corporate profits and retained earnings. The central
pointisthat,althoughtheriseininterestrateswillincreasepersonalincomes,ifthe
savingspropensityofthepersonalsectorislowerthanthatofthecorporatesector
(whichislikely),itwillleadtoafallintotalsavings(Akyuz,1991).
More importantly, whether for the above reasons or others, empirical evidence
from many countries, particularly Asian countries, which liberalized their credit
marketsin
the
1980s
and
1990s
and
increased
real
interest
rates
did
not
indicate
a
systematicrise inaggregatesavings. AsChoandKhatkhate(1989)notedintheir
influentialanalysisofthefinancialliberalizationexperienceoffiveAsiancountries
(Indonesia,Malaysia,Philippines,RepublicofKoreaandSriLanka):
Itwasbelievedthattheremovaloftherepressivepolicieswouldboostsaving. Thesurveyinthis paper of the consequencesof reformsdoes not reveal any systematic trend or pattern in
regard tosaving (andalso investment), though itclearlydemonstrates that reformhasgreatly
contributedto thefinancializationofsavings. Inmostofthesecountries,savingschanged ina
randomfashion.
Akyuz (1991) reached the same conclusion with respect to aggregate savings in
relation to Turkeys liberalization experiment during the late 1970s and in the
1980s.
Asfortheeffectsofcreditmarketliberalizationontheefficiencyoftheinvestment
allocationprocess,leavingasidethedisastrousconsequencesofsuchliberalization
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intheSouthernConecountriesinthe1970s,manysuccessfuleconomieshaveused
subsidiesindeednegativeinterestratesforlongperiodsoftimeasanimportant
partoftheirindustrialpoliciesduringthecourseofeconomicdevelopment. This
hascertainlybeentrueofJapan,whichprovidednegativerealinterestratestoits
favoured corporations for much of the postwar period of its most rapid
industrialization
(1950
to
1973).
Thus
Sachs
(1985)
notes
in
relation
to
Japan:
Domestic capital markets were highly regulated and completely shut off from world capital
markets. The government was the only sector with access to internationalborrowing and
lending. Foreign direct investment was heavily circumscribed, with majority ownershipby
foreignfirmsboth legallyandadministrativelybarred. Duringtheearly tomid1950s,abouta
thirdofexternalfundsfor industrial investmentoriginated in loansfromgovernment financial
institutions,atpreferential rates thatvaried across firms and industries. These state financial
institutionsremainedanimportantsourceofcheapfinancinguntilthe1960s.
AsAmsden (1990)pointedout, subsidiesanddirected creditwerealsoa central
feature of the Republic of Koreas highly successful industrial policy during the
previoustwodecades.
To sum up there is enough evidence to indicate that, contrary to the Stanford
school,ahighinterestratepolicybasedonfinancialderepressionwasapparently
notregardedasbeingsuitablebymanydevelopingcountries. Themostsuccessful
economiesinEastAsiadidnotfollowsuchpolicies. Policymakersindeveloping
countries ordinarily try to maintain low interest rates in order to encourage
investmentandgrowth. Inthatsense,thereisunlikelytobemuchdifferenceata
practicallevel intheperformanceofIslamicandnonIslamiccountriesinthereal
world. However,ataconceptuallevel,thedifferencebetweenthetwoparadigms
is huge. Islamic scholars do not find anyjustification for positive interest rates.
Nevertheless, the fundamental flaw in themainstream stricturesagainst thezero
interestratepolicyofIslamicfinancewasthatitfailedtotakeintoaccountthefact
that although the policy did not reward financial investment with interest
payments, profits on capital and enterprise were fully allowed, and indeed
encouraged.
An economic system where the capital is rewarded according to its earning
capacity could be entirely adequate for achieving sufficient savings and
investments for economic growth,and forallocating them efficiently. The main
propositionofIslamicfinanceisthatthereturntocapitalisdeterminedexpostand
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would be based on the return to economic activity in which the capital was
employed. Savingsand investmentwouldbedeterminedby thisexpost rateof
returnoncapital.Indeed,subsequentresearchshowedthattheIslamicsystemcan
bebasedentirelyonequitycapital,withoutdebt,andisthereforeoftenmorestable
than the conventional systembased on debt. This question willbe discussed
further
in
section
IV
where
the
Modigliani
and
Miller
theorems
and
their
implicationsforoptimalfinancialstructureforfirmswillbeanalysed.
Thisdiscussionraisesanimportantquestionforconventionaleconomists,whether
aneconomicsystemrequiresanexanteinterestratetofunctionefficiently. Here,
ProfessorMirakhor(2011)hasremindedusthattheArrowDebreuHahnsystemof
generalequilibrium,togetherwithitswelfarepropertiesdoesnothaveanexante
interest rate in the analysis. This system is totally viable and is indeed the
crowning
glory
of
modern
economics.
Adding
an
extra
variable
such
as
the
interestratewouldoverdeterminethesystemandwillbedifficulttointerpret.See
alsoMilgate(forthcoming).
Itisalsointerestingtonotethatbecausethereiscompetitionbetweenconventional
investorsandinvestorsinIslamicbanksthereisnotlikelytobemuchdifferencein
theratesofreturn(interestinthecaseofconventionalbanksandshareofprofitsin
thecaseofretailIslamicprofitandlosssharing(PLS)accounts)earnedbythetwo
groups.
This
hypothesis
is
confirmed
by
a
recent
IMF
study
which
compares
the
rateofreturnfrom thetwokindsofbanking institutions inMalaysiaandTurkey
overtheperiodJanuary1997toAugust2010(seeCevikandCharap2011).
Thedatarevealed,asexpected,ahighdegreeofcorrelationbetweenconventional
depositratesandtherateofreturnonretailPLSaccountsinMalaysiaandTurkey.
Between January 1997 and August 2010, a correlation of one year term
conventionalbankdepositratesandarateofreturnforPLSaccountswas91per
centforMalaysiaand92percentforTurkey. Theeconometricresultsshowstrong
evidence of cointegration between conventional bank deposit rates and PLS
returns over the long term. Granger causality is found between conventional
deposit rates and the rate of return on PLS accounts both in levels and first
differences. AnimportantresultbasedonpairwiseGrangercausalitytestsindicate
thatthenullhypothesisthatchangesinPLSreturnsdonotGrangercausechanges
inconventionaldepositratesbothinMalaysiaandTurkeycannotberejected,but
the null hypothesis that changes in conventional deposit rates do not Granger
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causechangesinPLSreturnscanberejected. Theauthorsalsouseerrorcorrection
methodologyandfindthatcausalitytestsconfirmthefindingsbasedonpairwise
Grangercausalitytests(CevikandCherap,2011).
Thus,inbroadtermsanIslamicbankingsystemisanessentiallyequitybased
systeminwhichdepositorsaretreatedasiftheyareshareholdersofthebank.
Thereisthusnofixedpaymenttothedepositorsfortheirmoneybuttheyare
entitledtoashareoftheprofitsofthebank.
Inthisequitybasedsystem,corporategovernanceisratherdifferentthanintheconventionalsystem. Itwillbearguedbelowthatthisleadstoproblems
ofmoralhazardfortheIslamicbank.
ItwillbesuggestedfurtherthattheredistributivestanceofIslamiclawsleadstotheproblemsofmoralhazardforthedepositor.
Thisrequireseitherstrongethicsorverystrongregulation,orbothfortheresolutionofthesedifficulties.
Inviewof theirsignificance for the theoryandempiricsof IslamicFinance these
pointswillbeexaminedmorefullyinthenextsection.
III. ETHICALFOUNDATIONSOFISLAMICFINANCEAlthough the rejection of interest payments is an essential element of Islamic
finance,thefoundationsofthelatterlieincertainethicalprincipleswhichinturn
emanate fromQuranSunnah and legal and ethical reasoningofSharih scholars.
These in theirentirety constitute thebasis for Islamic finance. Ethicalprinciples
guiding Islamic finance include significantly: the avoidance of Gharar: The concept
applies to preventable ambiguity and uncertainty, Ahmed and Kohli (2011, p).
Principles of Islamic finance are implemented through contracts. Sharih law
coversconditions
of
contract
and
inter
alia
rights
and
freedoms
of
the
contracting
parties.
ImportantlythereisastrongredistributiveelementinIslamicfinance.AsProfessor
Mirakhornotes in the conventional system,rich help thepoor as ademonstration of
sympathy,beneficence,benevolenceandcharity. In Islam,themoreablearerequiredtoshare
the consequences of the materialization of idiosyncratic risks illness,bankruptcy, disability,
accidents and socioeconomic disadvantaged for those who are unable to provide for
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themselves. The economically well off are commanded to share risks of those who are
economicallyunabletousethe instrumentsofIslamicfinance.In Islamicfinance,therisksthat
would face the future generations are sharedby the present generation through the rules of
inheritance. Theserulesbreakup theaccumulatedwealthas itpasses fromonegeneration to
anothertoenablesharingrisksofalargernumberofpeople,Mirakhor(2011,p15).
ToillustratewithasimpleexamplefromanelementoftheIslamicbankingcode,
consider the case of a mortgagee with an Islamicbank. In Islamic finance the
normal mortgage contract carries an implicit and explicit assurance that if the
mortgageeisunabletopayhismortgage,thecontractwillentitlehimforhelpfrom
theBank.
Some economists argue that this will create a moral hazard for the mortgagee.
However,opinionsdiffer. Otherscholarssuggest that if themortgageedoesnot
obey the Islamic ethical code outlined above he or she willbe subject to severe
sanctionsfrommembersof thecommunity. SimilarlyKhanandMirakhor(1993)
arguethattheBankshavedirectandindirectcontrolovertheagententrepreneurs
throughbothexplicitandimplicitcontracts. Thisisthecasebecausebankscould
refuse furthercreditorblacklist theagententrepreneurandputat stakehis/her
credibility and respectability. Thisbrings in a strong deterrent to irresponsible
behaviour. However Sundararajan (2011) observes that this argument does not
changethefactthatthebankhasnolegalmeanstointerveneinthemanagementof
thecurrententerprisewhileitisdonebytheagententrepreneur.
To the mainstream economist, it seems very unlikely that adherents of Islamic
finance will be able to live up to such high moral standards. Conventional
economics invariably assumes that humanbeings are selfish and analyses their
activitieson thebasisof thatpostulate. If the sameassumptionof selfishness is
madeinrelationtotheparticipantsinIslamicfinanceitwillleadtoahugemoral
hazardproblemonthesideofthedebtor.
ThereissimilarlypossibilityofmoralhazardonthesideoftheBank. Thisarises
fromtheunrestrictedMudarabacontractwherethebankmanagesthedepositsatits
owndiscretion. This increases themoralhazard forabankas itmay indulge in
more risk taking, without adequate capital. As Sundararajan (2011) notes,
investment depositors in Islamic Banks do not enjoy the same rights as equity
investorsinconventionalinvestmentcompaniesbutdosharethesamerisks.
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For these reasons, Islamic finance poses considerable pressure on the Islamic
Financemanagementtomanagetheir investmentriskstoavoidmoralhazard. It
alsoposesconsiderablepressureonthefinancialregulatorstomonitorinvestment
andagency(bankintermediary)behaviourtoavoidpassingallrisksultimatelyto
thedepositor. A thirdunknown factor is thecertaintyof the shariahbankruptcy
courts
to
enforce
disputes
over
contracts
that
show
clear
signs
of
moral
hazard
(or
shirkingbyborrower/investeetoavoidhisrepayments).
Table 1 in theappendix outlines the main differencesbetween Islamic and non
Islamicbanks.Themostrecentempiricalresearchby theWorldBankeconomists
shows that conventional and Islamic banking are more alike than previously
thought. Differences inbusiness models if they exist at all do not show in standard
indicatorsbasedonfinancialstatementsinformation. Otherdifferences,suchascostefficiency,
seem tobe driven moreby country rather thanbybank type differences. Finally, the good
performanceofIslamicbanksduringtherecentcrisisappearstobedrivenbyhigherprecaution
in liquidityholdings an capitalization,butno inherentdifference inassetqualitybetween the
twobanktypes,Beck,Kunt&Merrouche(2010). Althoughbasedonratherdifferent
data and a different definition of the analytical problem, the World Bank
economistsconclusionsfromtheirempiricalstudysupporttheconclusionsofthe
IMFeconomists,CevikandCherap,asdiscussedintheprevioussection.
AlthoughasnotedinsectionI,Islamicfinancehasexpandedveryfast,itstillhasa
small share of world finance and is still in a niche market Tan (2009). Somerespected commentators argue that the market has concentrated on the
developmentof safe, shortterm financial instrumentsand ignored the longterm
market. It is fearedby these scholars thatbecauseofpathdependencywhich is
characterisedbymanyeconomicevents, the Islamic finance industrymaysimply
continuetooperateontheshortendofthemarket. Indeed,thesewellwishersof
Islamic finance would like to takeamajor step forward and developan Islamic
stockmarket formeeting theneedsof the Islamic investors for investmentswith
longtermhorizons. Thisimportantquestionwillbeexaminedindetailinsection
V.
IV. MODIGLIANIANDMILLERTHEOREMSHavingexaminedthetwobasictenetsofIslamicfinanceweshallnowmoveonin
thesecondpartofthepapertoconsiderafundamentaltenetofmoderneconomics,
namely the so called Modigliani and Miller (MM) Theorems concerning the
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optimal financial structure of firms. We shall also analyse the feasibility and
desirabilityofestablishing stockmarketson Islamic rules toassist thegrowthof
Islamicfinance.
Sincethelate1950sanduntilrecently,themodernneoclassicalviewoffinancehas
beendominatedbythesocalledirrelevancetheoremsassociatedwithModigliani
and Miller (1958, 1961). In seminal contributions, starting with their pioneering
1958paper,ModiglianiandMillerputforwardtwocentralpropositionsaboutthe
theory of finance. They showed that in fully developed capital markets, under
fully idealised neoclassical assumptions of perfect competition, no transaction
costs,no taxation andnobankruptcy, even inaworldofuncertainty, the stock
marketvaluationof the firm is independentof its financingordividendpayout
decisions. On the basis of certain further restrictive assumptions about
expectations
and
the
nature
of
uncertainty
(e.g.
uniformity
in
expectations
held
by
allinvestorsonthestockmarket),itwasestablishedthatthemarketwouldvalue
thefirmssharesentirelyonthebasisofitsearningsprospects;sharepriceswould
beinvarianttothecapitalstructureofthefirmortotheextenttowhichitresortsto
internalorexternalsourcestofinanceitsinvestmentplans.
Miller(1991)providesanintuitiveexplanationfortheMMtheoremswiththehelp
ofananalogy.Thinkofthefirmasagigantictubofwholemilk.Thefarmercansellthewhole
milkasitis.Orhecanseparateoutthecream,andsellitataconsiderablyhigherpricethanthe
wholemilkwouldbring.TheModiglianiMillerpropositionsays that if therewerenocostsof
separation,(and,ofcourse,nogovernmentdairysupportprogramme),thecreamplustheskim
milkwouldbring the samepriceas thewholemilk. Vallimil furtherelaborateson this
explanationinthefollowingterms:theessenceoftheargument isthat increasingthe
amountofdebt(cream)lowersthevalueofoutstandingequity(skimmilk)sellingofsafecash
flowstodebtholdersleavesthefirmwithmorelowervaluedequity,keepingthetotalvalueon
thefirmunchanged.Putdifferently,anygainfromusingmoreofwhatmightseemtobecheaper
debt is offsetby the higher cost of now riskier equity. Hence, given a fixed amount of total
capital, the allocation of capitalbetween debt and equity is irrelevantbecause the weighted
averageof the twocostsofcapital to the firm is the same forallpossiblecombinationsof the
two.
At a deeper level, the Modigliani and Miller theorems suggested a dichotomy
betweenfinanceandtherealeconomy:corporategrowthandinvestmentdecisions
were dictated completelyby real variables such as productivity, demand for
output,technicalprogressandrelativefactorpricesofcapitalandlabour. Finance
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in this paradigm is always permissive and simply facilitates the investment
process.
Asinthecaseofneoclassicaleconomics,thenormalKeynesianperspectiveonthe
roleof finance in investmentandeconomicgrowthalsoassumeswelldeveloped
capital markets. However, this perspective does not postulate perfect capital
markets in the sense that the relevant informationon costs, reliabilityandother
aspectsofthetransaction,isnotavailableonequaltermstoalltheparticipantsin
themarket. AccordingtotheKeynesianview,corporateinvestmentisessentially
determinedbyanimalspirits,bybusinessmensconfidence,byexpecteddemand
andby the cost of capital. The latter variable in practice is regarded asbeing
relativelyinsignificantcomparedwithdemandfactors.
As they do not accept the assumption of perfect capital markets, Keynesian
economistsdo not generallybelieve that the Modigliani and Millerpropositions
areoperationalintherealworld. Theseneoclassicalirrelevancetheoremsalsorun
contrary to the traditional conception of a firms investment and financing
decisions. The traditionalviewwas a socalled peckingorder theoryof finance
(Donaldson, 1961; Myers, 1984 and 1985; Fazzari, Hubbard and Peterson, 1988),
which suggested that firms always preferred internal to external finance and, if
theyhadtouseexternalfinance,theywouldprefertoemploydebtand onlyasa
last
resort,
equity
finance.
The
firms
capital
structure
and
its
dividend
pay
out
decisions, in this analysis, were important variables which had an independent
influenceonitsshareprice. Moregenerally,thenonavailabilityoftheappropriate
kind of finance could constrain a firms growth or investment plans: this
suggestion was often incorporated in the postwar microeconomic investment
models in theKeynesian spirit. MayerandKuh (1957)andMayerandGlauber
(1964)areclassicreferences.TheseissueshavebeencarefullyexaminedinStiglitz
(1998and2005).
Paradoxically, the above traditional theory of finance hasbeen resurrected and
revalidatedbyanumberoftheoreticaldevelopmentsinthelasttwodecadeswhich
attempttorelaxsomeofthehighlyrestrictiveassumptionsoftheModiglianiand
Millerpropositions. With respect to the latter, itwasnotedat thesimplest level
thatiftaxationandpossibilityofbankruptcyandfinancialdistressareintroduced
intotheanalysis,thiswouldproduceanoptimalcapitalstructureforthefirmand
thus invalidate the ModiglianiMiller irrelevance theorems. Many corporate tax
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systems, for example, allow interest tobe deducted as costs, which provides a
significanttaxadvantageintheuseofdebtfinance. Thereis,however,atradeoff,
sincetoohighalevelofdebtincreasestherisksofbankruptcyorfinancialdistress
inaneconomicdownturn. Thissimpletradeoffmodel leadstoanoptimaldebt
equityratioforthefirm,whichmaximizesitsstockmarketvaluation.
Morecomplexconsiderationsandtheoreticaldevelopmentsinvolvingasymmetric
informationbetweeninsiders(managers)andoutsiders(creditorsorshareholders),
problems of adverse selection, moral hazard, agency costs, signalling and
transactioncostsleadtodifferentcostsofthevariousformsoffinanceandcanbe
shown tobebroadly compatible with the pecking order type theory outlined
above (Theclassicreferencehere isMyersandMajluf,1984). Ingeneral, this far
richer and more complete analysisof the issuespoints to the significanceof the
corporate
capital
structures
and
the
financial
decisions
for
the
real
economy.
At
theveryleast,thenewmodelsofthefirmsuggestthatfinanceisnotsimplyaveil,
but that therearevery important interactionsbetweencorporate financeand the
realeconomy. Thus,unliketheneoclassicalinvestmentmodels(seeinparticular
the widely acknowledged and valued contributions by Jorgensen and his
colleagues) which dominated the profession in the 1960s and 1970s, many
economistssubsequently in the lightof thenew interpretationofMMTheorems,
particularly the postKeynesian ones, came to regard cashflow and corporate
retainedearningsasbeingasignificantconstraintonafirmsinvestmentdecisions.
Howeverourmainconcerninthispaperisnotsomuchwithcorporateinvestment
decisions,but with the question of the financial structures of Islamic and non
Islamic firms. Stiglitz (1988)hasobserved thatunderverygeneral conditions if
thereisnochanceofbankruptcythenfinancialpolicyhasnoeffectonthevalueof
thefirm;thereisnooptimaldebtequityratio. Thissuggeststhatundertheneo
classicalassumptionsofMMTheorems,anyfinancialstructureforIslamicfirmsis
optimal, including that of all equity and no debt. However, if these strict
assumptionsarerelaxed,particularlywhenthereisarealpossibilityofbankruptcy,
thefirmvaluationwilldependonitsdebtequityratio. Thus,foranyspecificfirm
there willbe a corresponding optimal debtequity ratio. There is no reason to
believethatIslamicfirmswouldattempttoachieveorwouldhaveachievedtheir
respectiveoptimum financialstructures in termsofdebtequityratios. Does this
make Islamic firms less efficient? The answer is not necessarily sobecause the
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Hence, there is essentially no differencebetween the nonIslamic finance lender
andIslamicequitycontractintheserespects. Theconventionallenderprotectshis
ownrisksandshifts thesebycontractingwith theborrower, to includecollateral
and guarantees. If however, the real interest rate rises, the DCF value of the
borrowersassetsdeclineandrealvalueofliabilitiesincreaseandhemaygo into
economic insolvency. At the same time, the collateral value of the lenders
holdingsof
collateral
also
declines,
(especially
if
they
are
land
or
equity).
Thus,
at
higher real rates of interest, especially during a crisis, theborrower moves into
economic insolvency and therefore (nontransparently) transfers the insolvency
risktothelendersandholdersofhispaper. Thisriskreversionisidenticalinform
forIFornonIFfirms.
There is a further cost ofbankruptcy (transactions cost in time, legal fees etc.)
whichtheborrowerorinvestormayhavetoinvestinsoastorecouptheirloanor
investment. Thus,ifbothIFandnonIFcontractsinvolveinvoluntaryrisksharing,
then theonlyrealdistinguishing featurebetween the twosystems iswhether the
bankruptcylawsarestrongenoughandefficientenoughforenforcement.
In the IF contract, there is a moral or nontemporal sanction on theborrower,
hoping that this soft power willbe more effective than hard power legalor
other means of enforcement to force theborrower to repay. The reason is that
there is information asymmetrybetween theborrowers true solvency and the
lender/investor. Theborrowermayengageinlyingorhidinghistruesolvencyin
orderto
pass
as
much
losses
as
possible
to
the
lender
and/or
investor.
We
cannot
judgeaprioriwhetherIFssoftpowerisnecessarilybetterthanthelegalpowerof
debtenforcement. Thisdependsonthecircumstancesofthecase,thelegalpowers
inacountry,andtheeffectivenessofthecourtsetc.
Toputitclearly,alldebtorrisksharingcontractssufferfrommoralhazard. Ifthey
arenotenforcedagainstcheatingorfreeriding,thenriskswillpasstothesolvency
holder/lender. Insimpleutilityterms,whenthemarginalbenefittotheborrower
ishigherthanthecostofsanctions,thenhewillnotpay. Animportantquestionis
therefore whether sanctions are real enough for the borrowers to make thenecessary adjustments so that if they cannot pay today, they shall at least pay
tomorrow.
Itisarguablethatthecostsofbankruptcytotheborrowersintermsofconventional
financearelowerfortheIFborrowerthanforthenonIFborrower. Inthecaseof
the latter therearenotonly the laws relating tobankruptcybutalsodaily court
judgementsimplementingthelaw. Thiswilltendtomaketheloancontractmore
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transparentandprobablymorepainful incaseofdefault. It isworthnoting that
thebasic lawsonbankruptcydiffergreatlybetweenadvancedcountries,notably
theUSandtheUK. InbroadtermstheUKlawislessuserfriendlytotheborrower
than the US law which has the Chapter 13 provisions for allowing the firm to
continueasagoingconcernforalongerperiodthanwouldnormallybepermitted
by
English
receivership
arrangements.
It
may
also
be
observed
that
because
of
the
novelty of Islamic finance there may be nonuniform implementation of the
bankruptcylawsforIslamicfirms. Itisnotclearhowmanycasesofbankruptcyin
Shariah law are ever settledby Shariah courts. It is also not clear whether the
judgementsofthesecourtsareacceptedmoregenerallybythepublicandbynon
Islamiccourts.
The conclusion of this section is that whether IF or nonIF is more effective in
avoiding
moral
hazard
would
depend
on
the
whole
financial
infrastructure
of
risk
management systems, regulatory systems and the court systems. If Islamic
Financial systems end up with lower debt/equity as a whole than nonIslamic
systems, then the IFsystem is likelytobeable tocushionshocksasawhole,but
thisisaquestionofpractice,notoneoftheory.
VI. THEROLEOFTHEISLAMICSTOCKMARKETIslamic economists greatly favour the establishment of a stock marketbased on
Islamicprinciples inorder to further theexpansionof Islamic finance. Longago
ProfessorMetwally(1984)observed:InanIslamiceconomywhereinterestbearingloans
areprohibitedandwheredirectparticipationinbusinessenterprise,withitsattendantrisksand
profit sharing, is encouraged, the existence of a wellfunctioning Stock Exchange is very
important.Itwouldallowforthemobilizationofsavingsforinvestmentandprovidemeansfor
liquidity to individual shareholders. However, existing Stock Exchanges in nonIslamic
economieshavemanydrawbacks. Theygeneratepracticessuchasspeculationandfluctuations
insharepriceswhicharenotrelatedtotheeconomicperformanceofenterprises. Thesepractices
areinconsistentwiththeteachingsofIslam.
Very recently, one of the foremost scholars of Islamic finance, Professor Abbas
Mirakhor(2011),hasarguedforgovernmentinterventiontodevelopavibrantand
activestockmarketinIslamicfinancecountries. This,hesuggests,canbejustified
on many grounds, but, importantly, empirical evidence has shown a strong and robust
relationshipbetween financial development, including an active stock market and economic
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growth.Hegoesontoobservethat..arguably,thestockmarketisthefirstbestinstrument
ofrisksharing.Developinganactiveandefficientstockmarketcanpromoteinternationalaswell
asdomesticrisksharingwhichrendertheeconomyanditsfinancialsystemresilienttoshocks.
It is appropriate to start this analysis with a discussion of these issues in
conventionaleconomics. Theadvantagesanddisadvantagesofthestockmarkets
havelong
been
the
subject
of
acute
controversy
in
mainstream
economics.
In
the
first instance, we willbriefly review this debate and draw its implications for
Islamicfinance.
Inconventionaleconomics,JohnMaynardKeynes(1936)wasthe leadingcriticof
the stock market. He likened it to a gambling casino and warned that people
shouldnotbesurprisedbyunfavourableoutcomesiftheinvestmentdecisionsofa
nation are left to the vagaries of a casino. In contrast, like the Islamic scholars
above,the
mainstream
exponents
of
the
stock
market
believe
that
it
contributes
to
developmentthroughavarietyofchannels. Itcouldraisesavingsandinvestment
bymaking itpossible for individualsandhouseholds topurchasea fractionofa
shipyardorasteelmill,therebyspreadingtherisk,withoutwhichinvestmentmay
notoccuratall. Similarly themonitoring functionperformedautomaticallyand
fromtheperspectiveofanentrepreneur,costlessly,bythestockmarketalsohelps
raiseinvestment. Moreover,awellfunctioningstockmarketpurportedlyallocates
resourcesmoreefficientlythroughitsnormalpricingprocess,whichwouldaccord,
otherthingsbeingequal,highersharepricestoefficientfirmsandlowerpricesto
inefficientones.Furthermore,thetakeovermechanismostensiblyensuresthatnot
just thenew investment resourcesbutalso theexistingcapitalstock isefficiently
utilised. Inefficient use of existing resources is punished by the market for
corporate control through disciplinary takeovers.2 The other punishment is
throughbankruptcy and exit, which also carries with it the shame (sanction)
associatedwithbankruptcy.
How effectively the stock market can perform the above tasks depends on the
efficiencyofthreecriticalmarketmechanisms,namely(a)thepricingmechanisms
(b) the takeover mechanism and (c) the exit/bankruptcy mechanism. These are
central issues of debate on which there is a voluminous literature, which is
outlinedbelow.
2SeefurtherSingh(1992and2008)andtherelevantliteraturecitedinthesepublications.
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Theorthodoxparadigmof sharepricedeterminationpostulates that shareprices
areefficientbecause theyemanate fromperfectmarkets involving largenumbers
ofwellinformedbuyersandsellersinwhichnoonebuyerorsellercaninfluence
the price and where there is a homogeneous product, namely shares. There is,
however, an alternative paradigm indicatedby the passage from Keynes cited
earlier
that
characterizes
stock
markets
essentially
as
gambling
casinos
dominated
by speculators. Allenand Gale (2000);Shiller (2000); Shleifer (2000);Singh etal
(2005),BakerandWurgler(2007);HongandStein(2007)andnotleaststudentsof
behaviouralfinance[seeforexampleBarberisandThaler(2003);Hongetal(2007)
andBakeretal (2007)] formalize thevariouselementsof thisparadigm. Inbrief,
thisliteraturesuggeststhat,inthefaceofahighlyuncertainfuture,sharepricesare
likely tobe influencedby the socalled noisetraders, andby whims, fads and
contagion. For similar reasons of psychology, investors may attribute much
greater weight to nearterm price forecasts rather than historical longterm
performance. This lineofreasoning is taken further in thegrowing literatureon
behaviouralfinance.
Untilrecently,theempirical literatureonsharepriceshasbeendominatedbythe
socalledefficientmarketshypothesis(EMH),whicharguesthatrealworldshare
prices are efficient in the sense that they incorporate all available information
(Fama,1970).Inthe1980sand1990s,with(a)the1987USstockmarketcrash,(b)
themeltdown in theAsianstockmarkets in the1990sand (c) theburstingof the
technology stocksbubble in 2000, the EMH has suffered fundamental setbacks.
AlanGreenspan (1998)hascommentedas followson thereasons for (a)and (b):
At one point the economic system appears stable, the next itbehaves as though a dam has
reached abreaking point, and water (read confidence) evacuates the reservoir. The United
Statesexperienced suchasuddenchangewith thedecline instockpricesofmore than20per
cent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a
change in the fundamentalsof longtermvaluationson thatoneday.Kindleberger (1989)
similarlydocumented about thirty casesof unwarranted euphoriaand excessive
pessimismon the stockmarkets since theSouthSeabubbleof1720. He termed
theseepisodesasmanias,panicsandcrashes.
JamesTobin (1984)madeananalyticallyusefuldistinctionbetween twokindsof
efficiencyofstockmarkets,(a)theinformationarbitrageefficiencythatensuresthat
all information concerning a firms shares immediately percolates to all stock
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marketparticipants,ensuringthatnoparticipantcanmakeaprofitonsuchpublic
information; (b) fundamentalvaluationefficiency, that is, sharepricesaccurately
reflect a firms fundamentals, namely the long term expected profitability. The
growing consensus view is that, in these terms, stock markets may atbestbe
regardedasbeing efficient in the senseof (a)but far frombeing efficient in the
economically
more
important
sense
(b).
Thus
EMH,
as
identified
in
(a),
is
compatiblewithsharepricesnotreflectingfundamentalvalues. Amoredetailed
discussionaswellasotherexamplesofsharepricesevidentlydepartingfromtheir
fundamentalsisprovidedinSinghetal(2005).
Apart from the normal mispricing, which is particularly likely tobe severe in
developingcountriesastheirfirmsdonothavealongtrackrecord,sharepricesin
developing countries are more volatile than in advanced countries [see further
Singh
(1997);
El
Erian
and
Kumar
(1995)].
Share
price
volatility
is
however
a
negativefeatureofstockmarketsforseveralreasons.First,itreducestheefficiency
of thepricesignals inallocating investmentresources. Secondly, it increases the
riskiness of investments and may discourage riskaverse corporations from
financing theirgrowthbyequity issuesand indeed from seekinga stockmarket
listingatall. Thirdly,at themacroeconomic level,ahighlyvolatilestockmarket
mayleadtofinancialfragilityforthewholeeconomy(Singh1997).
We
now
take
up
the
belief
of
Islamic
scholars
that
the
development
of
the
stock
marketwould lead to fastereconomicgrowthand fastergrowthofemployment
and consumption. This isavariantofwhatSingh (2008)has termed the World
Banksnaturalprogressionargument. TheWorldBankwhichnaturallysupports
theestablishmentof,andencouragementofstockmarkets throughout theworld,
basicallyarguesthatthestockmarketistheemblemofdevelopmentofacountry.
As a country develops, it tends to establish stock markets. Stock markets can,
therefore,be regarded as an insignia of economic development. Unfortunately,
economichistoryisnotcompatiblewiththisinterpretation.
Twokindsofevidenceare relevanthere. The first is theobservation thatof the
economicmiracleswhichhaveoccurredinthesecondhalfofthetwentiethcentury,
hardlyanycanbeascribedtostockmarketdevelopment. Thus,inpostWorldWar
IIEuropetheItalianmiracle(veryfastgrowth),theGermanmiracle,theAustrian
miracleandinAsia,thejustlyfamousmiraclesofKoreaorTaiwan,didnotdepend
conspicuously on the equity orbond markets in these countries. Similarly, the
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24
secondkindofevidencerelevanthereconsistsofanexaminationofcomparative
growth rates over a longer one hundred years time span. Such an examination
reveals that thebankbased countries (for example Germany andJapan) have as
good if not abetter longterm record of economic growth than the US and UK.
Pagano(1993),notesthattheItalianstockmarketwasbiggerahundredyearsago,
than
it
was
in
1990.
The
Italian
economy
evidently
grew
during
these
hundred
yearswithoutanyexpansionofthestockmarket.3
It is important, in this context for Islamic scholars toalsobear in mind that the
stock market often spontaneously leads to the development of a market for
corporate control and this market is regardedby traditional economics as the
evolutionaryendpointofstockmarketdevelopment. Evidence,however,isallto
thecontrary. Researchshowsthatthetakeovermechanismasitworksinthereal
world
is
highly
flawed.
Selection
in
the
market
for
corporate
control
takes
place
noton thebasisofperformancealone,but,bothonperformanceaswellas size.
Thus,a large relativelyunprofitable firmhasagreaterchanceof survival thana
smallprofitablefirm. Thishasadverseconsequencesforeconomicefficiency.See
furtherTichy(2002),Scherer(2006),Singh(2008).Themarketforcorporatecontrol
insteadofbeingavehicleforeconomicefficiency,exacerbatestheshortcomingsof
stock marketby encouraging speculative takeovers of whole companies rather
than just buying and selling of few shares of individual companies. Thus, in
conventional economic terms, neither the pricing mechanism nor the takeover
mechanismintherealworld,arehelpfultoeconomicefficiencyanddevelopment.
Thethirdissueistheeffectivenessoftheexitmechanismforfailedcompanies,such
as delisting from the stock market or actual bankruptcy. The important
disciplinarianroleoftheexitmechanismisthatfailedinstitutionsshouldexitand
thatthereareconsequencesforfailure. Manyemergingmarketstockmarketsdo
not work well because of the lack of enforcement of rules or allowing more
delisting andbankruptcy of failed companies. Indeed, in a number of cases,
governmentshavebeenknowntointerveneinstockmarketstobailoutcompanies
introuble. Suchactiononlyengendersmoremoralhazardproblems,erodingthe
disciplinaryroleoffinancialmarkets.
3 Apart from thisbroadbrush evidenceon themeritsof the stockmarket for economicgrowth, therearealsoanumberofeconometricstudieswhichreportmixedresults.Thesestudiesareoftenbasedonreducedformequations
wheretheresultsaredifficulttointerpretintermsofcausation.SeeSingh(2008);Levine(1997).
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Fromtheexperienceofrealworldstockmarkets,itisdifficulttoseeapriorihow
such an institution would positively benefit Islamic finance, without stringent
supervisory,corporategovernanceandexitmechanismsinplace.
VII. SUMMARYOFTHEMAINFINDINGSANDCONCLUSIONAsthisessayhasrangedoverseveralfieldsofconventionalandIslamiceconomics,
it willbe useful to summarise the main theoretical and empirical findings. The
paperhasfirstexaminedthecentraltenetsofIslamicfinancefromtheperspective
of conventional economic analysis. It started with the question of absolute
prohibition of interest payments in any form under Islamic finance. The main
conclusion isthat it ispossibletorunanefficienteconomicsystemoftheIslamic
kind, which has no interest payments,but which allows profits on capital and
enterprise.Suchasystem,basedtotallyonequityfinanceiscompletelyviableand
may,infact,bemorestablethanapartdebtfinancedconventionalsystem.
Conventional economics legitimately uses interest rates zero, negative and
positiveratesforitsanalysisofrelevanteconomicconditions.Thereis,however,
little evidence to support the McKinnon and Shaw hypotheses that financial
liberalisationnecessarily leads tohigh interest rateswhich in turngeneratehigh
savings, investments and economic growth. The highly successful East Asian
countriesemployedlow,evennegative,ratesratherthanhighinterestratesduring
theirindustrialisation.
Asdeveloping country policy makersare prone to use lowbut positive interest
ratesinordertoencourageinvestmentandgrowththereis,inpracticalterms,very
littledifferencebetweenconventionalandIslamic(zerointerestrate)paradigmsin
theirpracticalapplications.Theratesofreturnondeposits inconventionalbanks
andthoseofprofitsharingaccountsinIslamicfinancetendtobehighlycorrelated
andbroadlyofsimilarmagnitude.
AnanalysisofthesecondmajortenetofIslamicfinance,namely,itsethicalsystem
indicates that ifhumanbeings strictlyadhere to the requirements of the Islamic
ethics therewouldbe fewmoralhazardproblems in Islamicbanking.However,
sincetotaladherencetotheIslamicethicalsystemisunlikelyformostindividuals,
importantmoralhazardissues,bothonthesideofthedepositorsinIslamicbanks
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aswellasonthesideoftheIslamicbankthemselvesloomlarge.Thesewouldneed
toberesolvedintherealworldbyextensiveregulation.Itisamootpointwhether
such far reaching regulation of individual ethicalbehaviour is at all feasible or
desirable.
Turning to the relevant chief tenetsof conventional economicswe first find that
there is no straight forward application of Modigliani and Miller theorems to
Islamic firms and banks. This is because the assumptions underlying these
theoremsofnotransactionscosts,perfectmarkets,notaxationandnobankruptcy,
depart considerably from the real world situations. If these assumptions are
relaxedtoconformmoretotherealworldthenonewouldgetanoptimalcapital
structure,i.e.someparticulardebtequityratioforaspecificfirm.However,thisis
optimalityfromthepointofviewofthefirmratherthanthepointofviewofthe
society
as
a
whole,
so
it
will
be
difficult
to
reach
the
judgement
that
Islamic
firms
havenonoptimalcapitalstructuresonthebasisofModiglianiandMillertheorems
alone.
Although for MM theorems, the concept ofbankruptcy is important, in the real
world, it is its costs and who pays these which are significant factors in
distinguishing between the two systems. The real issues are information
asymmetry, the principalagent (contract) and insolvency costs, and whether or
not,
the
operation
of
these
concepts
leads
to
a
hard
budget
or
a
soft
budget
constraint for theborrowing firms which do not wish to pay and to shift the
burdentothelender. IntheIslamicfinancecontractthereisanadditionalimplicit
sanctionagainst this typeofmoralhazardof theborrowerwhichmaybe called
softpower.Thismaybeinsomeinstancesmoreeffectivethanthehardpower
ofthebankruptcylawsbutitisdifficulttoimaginethatitwilldosoeverytimeor
inmostcases.
The paper considers the desirability of establishing stock markets to further the
completion of the Islamic finance programme and to help with its expansion. It
providescriticalbutconstructivecommentsonthisimportantproposal. Thepaper
suggeststhatbecauseitisimpossibletodistinguishbetweenspeculativeandnon
speculativeinvestmentstrategiesitwouldbedifficulttoestablishintherealworld
astockmarketwithIslamicethicsinwhichnonspeculativestrategiesarefollowed
byallplayers. Thepaperalsofoundthatitisnotcorrecttosaythathistoricallythe
stockmarkethasplayedakeyroleineconomicdevelopmenteitherintheperiodof
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fastgrowthof theworldeconomy since theSecondWorldWarorovera longer
periodcomprising the lasthundredyears. Incountries likeJapanandGermany,
banks rather than the stock market have played the pivotal role in economic
development.InthepostWorldWarIIperiod,theGermanmiracle(ie.historically
fastgrowth),theItalianmiracle,theAustrianmiracleandinEastAsiatheKorean,
the
Japanese
and
the
Taiwanese
miracles
were
not
conspicuously
aided
by
the
stockmarket. InGermany,untilabouttwodecadesagotherewereonly650firms
listed on the stock market of which only 25 were actively traded. Similarly, in
setting up their economic system after the Second World War, the Japanese
deliberately favoured the development of the mainbank system rather than the
stockmarket(Singh1995,2008). Thepaperdrawsattentiontootherdrawbacksof
thestockmarketsandtheassociatedmarketforcorporatecontrolwhichwillnotbe
helpfulforanIslamiceconomy.
In conclusion, a conventional stock market would not be useful for Islamic
economiesbutaShariahcompliantstockmarketwithoutspeculativeplayersmay
bedifficulttoorganise. Yet,thesearchforanethicalstockmarketmustcontinue.
To sum up and to conclude briefly, the two systems, the Islamic and the
conventionalhaveexisted sideby side for the last twoor threedecadeswithout
any serious conflict. The conventional system, if anything, has helped the
development
of
Islamic
finance.
As
Islamic
finance
becomes
stronger,
there
may
be room for conflictbut it is not inevitable. Cooperationbetween these two
systemsiseminentlydesirableandfeasible. TheconventionalandIslamicfinance
maycooperateorevencompetetoproducethebestoutcomeforcommonprojects
suchas theprovisionofcheapbanking for theworldspooror for investment in
environmentalundertakings. Thereareareasinwideningaccesstofinancewhich
may be more desirable under Islamic finance because of the ethical basis of
funding. It is arguable that conventional finance,because of its use of debt, is
likelytohaveafaster,butmoreunstable,growththanIslamicfinance. Thuseach
systemhasitsstrengthsandweaknessesandonecaneasilycoexistwiththeother
tothebenefitofhumankind.
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TableI:AComparisonbetweenIslamicandConventionalBanking
Source:IslamicFinance:WritingofV.Sundararajan,Eds.J.AhmedandH.S.Kohli,2011.
Features Islamicbanking Conventionalbanking
Guaranteeofthecapital
Valueof:
Demanddeposits
Investmentdeposits
Rateofreturnondeposits
Mechanismtoregulate
Finalreturnsondeposits
Profitlossprofit(PLS)
principleapplies
UseofIslamicmodesof
financing:
PLSandnonPLSmodes
Useofdiscretionby
bankswith
regardtocollateral
Yes
No
Uncertain,notguaranteed
forinvestmentdeposits.
demanddepositsare
neverremunerated.
Dependingonbank
performance/profitsfrom
investment.
Yes
Yes
Generallynotallowedto
reducecreditriskinPLS
modes.Bywayof
exception,maybeallowed
tolessenmoral
hazardin
PLS
modes.
AllowedinnonPLS
modes.
Yes
Yes
Certainand
guaranteed.
Irrespectiveofbank
performance/profits
frominvestment.
No
Notapplicable.
Yes,always
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29
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